3 Reasons to Sell ZAGG

The smartphone accessory manufacturer has had a good ride, but the future looks shaky.

The incredible adoption rate for smartphones is still ramping up, with Apple's (Nasdaq: AAPL) iPhone leading the way. Plenty of new devices means lot of opportunity for companies such as ZAGG(Nasdaq: ZAGG) to jump in and sell you a screen protector, or a bottle-opening case, or a nifty case-stand-keyboard combo for tablets. Unfortunately for ZAGG, the feast is coming to an end.

Single product reliance: ZAGG makes the invisibleSHIELD screen protector, which covers smartphones and tablets and protects them from scratches. Last quarter, sales from invisibleSHIELD accounted for 48% of ZAGG's revenues, and the biggest problem is that ZAGG has no proprietary rights regarding the film used in this specific product. With regard to the proprietary rights the company does have, the company cautions that "no assurance can be given that ... the intellectual property rights that we have are sufficient to protect other persons from creating and marketing substantially similar products."

So the risks for similar products are known, but the real problem is with superior products. The iPhone, Galaxy line, and many Droids already sport Corning's (NYSE: GLW) Gorilla Glass. The glass is more scratch-resistant and thus less likely to need an invisibleSHIELD. While the product is not perfect, continued development by Corning could put a serious dent in future ZAGG sales.

Margin erosion: Because of its single product reliance and lack of competitive moat, ZAGG has felt obliged to enter into a huge range of product markets. The company has begun selling covers, earbuds, cases, and miscellaneous mobile accessories. All this expansion has hurt operating costs.

Starting in 2011, as diversification increased, operating-cost growth started to outstrip sales growth. The company increased sales by 135%, but costs grew 155%. Instead of being able to focus on the strong-margined but competitively weak invisibleSHIELD, the company has had to look to thinner-margin products.

Accounts-receivable growth: ZAGG products are specifically designed for each device. A cover that fits an iPhone is distinct from a cover that fits a Windows phone. That's why I worry when the company's accounts receivable grows 125% from Q1 2011 to Q1 2012. Revenue grew 106% over the same period.

ZAGG is increasing the speed and volume at which it's shipping, but as the lifecycle of a smartphone shortens, it's likely to start receiving more returns of unsold products that no longer fit the newest phones. With $37 million waiting to be collected, there's a big hole just waiting to open up under ZAGG's feet, if demand drops off.

The bottom lineThere is certainly a temptation to play ZAGG as an indirect way of getting into Apple. I don't think the company is poorly run, nor do I think it makes bad products. The problem is that ZAGG doesn't seem to be in control of its own destiny. If it does well, it will only be because no one comes along to compete. However, I believe the market is large enough for a meaningful competitor to come along and drive margins even further down as it cuts into ZAGG's market position.

As my colleague Austin Smith has said, the next few months could continue to be strong for ZAGG. It's the long-term future that's unknown. If I had invested in ZAGG and made a nice return up to this point, I'd sell out and get into Corning. I think the future of Gorilla Glass is going to keep it in handhelds for years to come. Obviously, individual investors should take their time before making those sorts of decisions and do all of their own research before making any moves.

ZAGG's strength came from its ability to see the niche market that no one else had seen. As more people see the market, their advantage will slowly fade. Luckily, the Fool has created a free report detailing the business behind The Next Rule-Breaking Multibagger. This one has a moat the size of an ocean, and investors are going to happy they got in early. Get the all the details from our report today.